Understanding Financial Statement Analysis- Techniques Purpose and Challenges
Financial analysis is the process of examining an organization’s finances for decision-making purposes. On the one hand, external parties use the information to evaluate the organization’s financial health for investment reasons (Subramanyam, 2014). Lenders also use financial analysis to decide whether they will extend a loan to an organization. On the other hand, internal organizational players use the information to develop sound financial management actions (Subramanyam, 2014). Top managers rely on financial analysis outcomes to determine the accurate effects of their decisions and the progress after that.
Analysts use various methods to understand the financial performance of an organization over a given period. The primary ones include horizontal analysis, vertical analysis, and trend analysis. First, vertically shows the relationship between different ledger items. The technique helps managers understand performance in terms of costs and incoming revenue.
On the other hand, horizontal analysis shows the performance of a business over a given period. It involves comparing a ledger component with the same item in the previous period to understand the trends over time (Subramanyam, 2014). If, for instance, the cost of goods increases by 10% but that is not reflected in the company’s revenue, then there could be other factors contributing to increased costs.
Finally, vertical analysis shows an organization’s performance for two or more periods. After setting the previous years as the base period, the current year’s performance will show whether the company is headed in the right direction or not. Incremental patterns show progress, while falling numbers imply that the organization is losing.
One of the limitations of financial analysis is its overreliance on monetary information, ignoring crucial non-monetary business factors. Also, financial accounting is based on the examination of interim reports, hence not offering a comprehensive business perspective (Faello, 2015). In addition, price changes are ignored when conducting financial analysis, yet prices play a crucial part in determining an organization’s revenue.
References
Faello, J. (2015). Understanding the limitations of financial ratios. Academy of Accounting and Financial Studies Journal, 19(3), 75.
Subramanyam, K. R. (2014). Financial statement analysis. McGraw-Hill Education.
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Discussion Forum 8: Financial Statement Analysis
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Understanding Financial Statement Analysis- Techniques, Purpose and Challenges
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